Our 401k Options Need Upgrading

Key Points:

• Assets in 401k plans are massive at $5.6 trillion as of March 31, 2020 (Source ICI).
• There are three main reasons why participants do not thrive like they should.
• Adding flexible mandates to investors’ portfolios can help solve these flaws.

401k Assets: There is a lot at Stake for Participants

As someone who has spent his entire career in the financial services industry, I get a lot of requests from friends and family to help them understand how to allocate their 401k plans. Sometimes we forget the industry has its own language and the lay person, who wants to learn and grow, does not find it easy to get the information they need to make the appropriate allocations. The statistics are pretty clear, most people will live longer than they expect and many of them risk outliving their assets. For most people, their home is the most important and valuable asset followed by their retirement assets. The difference between investing right and poorly can be the difference between having the assets we need as older people or running out of money unnecessarily. It’s fair to say, the industry needs to do a better job preparing participants so they can make the right decisions. Part of this process has to involve identifying what the problems are and offering better solutions and education.

Source: Personal Capital – a hypothetical example of retirement planning.

Three Problems Contributing to Having Less Retirement Money

This week I spent some time chatting with a friend and colleague about the good and bad he sees inside the 401k plan market. This Advisor is part of a $2 billion team and they spend a good portion of their time serving and marketing to 401k plans. Here is his assessment of the three most important reasons 401k participant does not achieve the full potential:

1. Most participants do not contribute enough and ignore the matching benefits.
2. Most participants let their emotions drive investment decisions making them sell low, buy high.
3. Most participants get overwhelmed by the plan choices and investment decisions in general.

There’s a lot to unpack here so let’s take them one at a time and expand on a few key areas.

Not contributing enough money on a regular basis.

This comes down to pure education because part of the reason people don’t contribute is because they get paralyzed with fear over making a bad decision. Even a bad allocation decision gets diluted with the benefit of time so we all just need to spend more time with participants to make sure they contribute regularly and understand that time is a major ally in the world of investing. Being paid a living wage is also a key here. The statistics are clear: the lower the wage, the less the participant contributes. In a country with high cost of living, lower income employees have less wiggle room so there’s significant reasons to defer 401k contributions so people can pay for daily consumption. If consumers are shown how much money they are leaving on the table by not contributing though, perhaps they would choose to invest more. At the very least, if the topic of investing weren’t so confusing, more participants would contribute to their 401k plan. A keyway to get more contribution is to have options that are easier to understand and appreciate.

Emotions will most often lead people away from making the right choices.

Most of us have seen the Dalbar studies that consistently show investors do much more poorly than the indices and versus their true potential. I have had three conversations with friends this year that went something like this, “I rode the market down in my 401k only to raise cash close to the bottom and haven’t gotten back in yet so I missed this massive rebound.” You know anyone that capitulated close to the bottom? I’ll bet you do. This game is hard, and we always have to remember to buy fear and sell euphoria. One of my favorite Advisors gives every client a framed picture with those words and says to put the picture somewhere prominent and that they will refer to it many times over the life of their relationship. It’s brilliant psychology.

Our industry does a poor job at helping investors self-diagnose so they can use this data to help build the right portfolio solution. Some investors have a base level of knowledge and engagement with their investments, outside and inside the retirement options, and many do not. For those that understand they are not interested in or capable of learning the options, some automation is required. That’s where Target Date Funds can add some value. But they are not generally as useful as they could be. Why? Because they primarily use static allocation plans based on a participant’s “risk score”. The problem with this score is two-fold:

1. Creating a risk-score tends to skew according to the current environment and is therefore more theoretical than realistic. Example: If I filled out a risk questionnaire during a market crisis I would likely score more risk averse than I might otherwise be or in the bubble 1999 environment when making money was “easy” I would likely score very high as someone willing to take more risk.
2. The risk score does not take into consideration what the current market risk is. Example: If a participant scores a seven on the risk profile and that portfolio allocation is associated with a 70% stocks and 30% fixed income allocation, the analysis does not compare that 70/30 recommendation with the potential risks and rewards across current markets. In early 2008 when the economic environment began to turn south, a 70/30 investor should have allocated more to 50/50 given the risks in the current market. Conversely, in early 2009 and with the markets cheap relative to their history, a 70/30 investor likely should have dialed up the equity weight given the attractive back-drop and after a market crash.

There’s another massive potential problem going forward: conventional wisdom says the older we get, the higher the allocation to traditional fixed income should be. Bonds are the “safe allocation” right? If bond yields have been falling since 1981 offering the mother of all investment tailwinds, what happens going forward as rates sit at almost zero? At the most important time in a person’s life, the industry is allocating more of our hard-earned assets to what could turn out to be the riskiest asset class. Bad idea.

Participants need better choices with more flexible, dynamic options that consider future risks.

Let’s focus on the masses of plan participants. We know most people do not understand the markets or style boxes and market caps generally. But they do understand and appreciate the concept of investing in what they know. Peter Lynch had the best active fund track record and constantly reiterated how important it was for investors to look around, see what’s popular, what consumers are buying, where the crowds were gathering, etc. The easier a fund is to describe, and the more logical and commonsense the approach, the better the adoption will be.

We also know that most participants do the wrong things at the wrong time. We also know that Target Date Funds take the responsibility out of the hands of the participant so they get more consistent exposures than they might otherwise get using their emotions as a north star. However, we also know what has historically been a safe-haven, may not always offer the safety as rates go to zero. Common sense dictates, there are times when it’s wise to take more risk (after a correction, recession for example) and times when dialing back the risky exposures is prudent (when markets are historically expensive, the economy is slowing, or when euphoric sentiment is driving up prices to unsustainable levels). Target date funds are a great first step, but they are not the most ideal solution. We think there’s a more effective, more commonsense way to help plan participants meet their long-term goals and help their chances of outliving their assets.

A Potential Solution:

The following are potential solutions for investors:

• Add a few highly flexible funds that turn over the allocation decisions to those more qualified. Let the professionals decide what styles, market caps, geographies to focus on and whether more or less risky exposure should be taken.
• Along with a static allocation suite (Target Date Funds), offer an auto-pilot solution that’s more dynamic.
• Add funds that are easily and quickly understood. Knowing what you own and why it is vital.
• A portfolio of highly recognized and admired brands allows participants to get involved with investing and own many of the world’s most admired companies.

Disclosure:
This information was produced by and the opinions expressed are those of the author as of the date of writing and are subject to change. Any research is based on the author’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however the author does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios managed by the author, and do not represent all of the securities purchased, sold or recommended for client accounts.  The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results.